Ignore Earnings Beat, Shake Off Herbalife Stock

Momentum in a stock like this always ends badly, and the ego war over HLF will make the crash even more spectacular

Herbalife (NYSE:HLF) — the diet shakes and nutrition supplements stock that has captivated Wall Street for five months — just reported strong earnings and is up about 10% in the past week.

So should you buy Herbalife? No way.

My negativity on Herbalife stock is partially because, like many diet or exercise stocks, history indicates a crash inevitably happens when the fad fades or a better alternative pops up.

But my bearish take is also partially because HLF remains the playground of Wall Street insiders. The short interest is big, there’s a board shakeup in the works, and this stock is being watched like a hawk by swing traders and speculators. That means the chance of a big move is likely, and makes the risk-reward tradeoff unpalatable for the vast majority of investors.

Sure, it’s nice if you’re right … but it will cost you a fortune if you’re wrong.

Of course, a look at the actual numbers shows a pretty compelling case to buy Herbalife stock and not fret. HLF posted stronger-than-expected earnings and raised its profit forecast for the year. Net sales were up 17%.

That’s all good news, and echoes the strong history of Herbalife earnings. The company has beat analysts’ earnings estimates for 17 consecutive quarters and has a five-year sales growth rate of over 25%.

Throw in a 3% dividend, and this stock seems a no-brainer, right?

Well, it’s worth noting that its second-quarter guidance fell slightly short of expectations. And while this tiny blemish isn’t enough to signal Armageddon, it is cause for concern.

That’s because despite Herbalife’s strong earnings history, you have to wonder how long the growth can keep up.

Click to Enlarge Take a look at the three charts of other diet stocks Medifast (NYSE:MED), Weight Watchers (NYSE:WTW) and NutriSystem (NASDAQ:NTRI) to the right and notice the volatility.

I am no fitness guru or personal trainer, but it doesn’t take a rocket scientist to make a list of about two dozen diet or exercise fads from the past few decades — Sweatin’ with the Oldies gave way to Tae Bo gave way to P90X. Each one catches on with eager and tubby Americans, then inevitably falls off the radar and is replaced by another fad.

I’m not convinced that Herbalife is anything unique or new, and I’m reluctant to expect the growth to continue forever. Sure, fighting obesity is a hot business as the U.S. tries to get healthy and the sports nutrition market is admittedly a lucrative and growing niche — see the growth of Gatorade and similar imitators, or the rise of GNC (NYSE:GNC) stores. But it’s also highly competitive and prone to new fads that prey on ever-changing consumer tastes.

Many momentum stocks are in the same boat, so I’ll admit that assessment is not enough to give up on Herbalife. But when you couple this with the cheerleading against the stock, the risk gets awfully large.

Some of the most powerful names on Wall Street continue to make this stock ground zero for their ego contest. Bill Ackman, who is betting against the nutritional products company, has a $1 billion bet against Herbalife. Meanwhile, bullish investor Carl Icahn is installing deputies on the Herbalife board to do his bidding and take the fight to Ackman and others.

Furthermore, before earnings, the short interest as a percentage of the float in Herbalife stock was pushing 45%.

Gambling on the expectations game is a dangerous business in momentum stocks that keep growing but might fall off a cliff simply because they are not growing fast enough — see Apple (NASDAQ:AAPL) for a recent example.

But when you add in the explosiveness of a high-profile hedge fund battle, it starts to get crazy … too crazy for the vast majority of retail investors.

Herbalife stock is up about 19% this year and very well might add a bit more by year’s end. But at $39, HLF is sitting almost exactly in the middle of the $24-$50 range in which it has traded since mid-December when the fireworks began in earnest with Ackman’s takedown.

Let the hedge funds toy with Herbalife stock and sit this one out. There are far less risky ways to make another 10% or 20% in 2013.

At a Glance

Sure, fighting obesity is a hot business as the U.S. tries to get healthy, and the sports nutrition market is admittedly a lucrative and growing niche. But it’s also highly competitive and prone to new fads that prey on ever-changing consumer tastes. Couple the risk of momentum ending abruptly with a massive hedge fund battle, and the downside risks could be severe -- with upside rather limited.